Our fund has invested in several companies in Canada, as we have found good values there over time. We like the Canadian economy, which is natural resource based, and Canada avoided many of the excesses in the U.S. housing market in 2006-9. Canada's debt to GDP level is also significantly below the U.S. level.
One Canadian stock we like is Softchoice (OTC:SFCJF), a business-to-business direct marketer of information technology hardware, software, and services to small, medium, and large businesses, and public sector institutions. Softchoice is the largest large account reseller (or LAR) for Microsoft (MSFT) in Canada, and one of Microsoft's top five LARs in the U.S. Microsoft and Cisco (CSCO) both sell 93% or more of their products through the channel, so these LARs are important partners who connect them to end-user customers. Softchoice has 42 offices and about 1,200 employees throughout North America to service these end-user customers.
Our fund focuses on companies with "Ft. Knox" balance sheets and large, sustainable free cash flow yields, and we believe Softchoice meets these criteria.
LTM results include $1b of revenues, 19% gross margin, and a 5% EBITDA margin or about $50m of LTM adjusted EBITDA. Softchoice has low margins but generates very high returns on invested capital (or ROIC) as working capital is tightly managed and capital expenditures are small. Softchoice holds very little inventory but instead sits between IT distributors like Ingram Micro (IM) and the end-user customer. Consequently, Softchoice has a very asset-light business model and its ROIC is close to 100%. (We define ROIC as EBIT divided by net working capital plus PPE a la Joel Greenblatt). This high ROIC business model results in large free cash flow generation with LTM FCF of about $39m.
Softchoice has about 20m shares outstanding at $13 for a market cap of $260m and a net cash position of about $50m at 9/30/12 for an enterprise value (EV) of about $210m. We believe Softchoice can sustainably generate $35m of FCF which results in a FCF yield of 16% unleveraged. Over the past five years, from 2007 to 2011, Softchoice has generated cumulative free cash flow (defined as cash from operations less capital expenditures) of about $130m or 65%+ of the current EV. Softchoice's business model is not capital intensive and requires only $5-$6m of capital expenditures per year.
Softchoice is using its powerful relationship with Microsoft to expand into higher margin services with its broad customer base. It has made selective acquisitions over the past five years to strengthen its market share with Microsoft and move into higher-margin service offerings, most recently Unis Lumin, a Canadian networking and managed services provider. Softchoice should benefit from its strong partner relationships with companies like Adobe (ADBE), Apple (AAPL), Dell (DELL), NetApp (NTAP), VMWare (VMW), and IBM (IBM), and increased technology spending by enterprise customers which allows them to drive greater efficiencies in a low-revenue growth world. It should also benefit from Microsoft's largest product launch in history.
We believe Softchoice is a much better business than it appears at first glance. If Softchoice continues to execute its high-ROIC business model and generate strong FCFs, the company could trade for 10x our FCF estimate of $35m plus $50m (or more) of net cash or about $20 per share, or almost 50% more than its current $13 share price.